If you are looking to invest or start saving, it is important to understand what compound interest is. In layman’s terms, it is the interest you earn on interest. Commonly used in investing, it makes your money grow exponentially over time.
Defining Compound Interest
Compound interest is the interest calculated on both the initial amount and the amount accumulated from previous periods. This exponential growth allows you to earn money faster than normal interest. The frequency of the compounding interest, whether that is annually, monthly, weekly or daily, depends on the financial product and determines how fast your money accumulates. Understanding the frequency of compounding interest simplifies specific saving goals. It helps you determine how long to save based on your needs. For example, if you invest $10,000 in a high interest savings account and accumulate $202 in compounding interest, next month interest will compound on $10,202, not just $10,000.
While compounding interest can fasten the saving process, it can also increase your debt. Borrowing money from financial products with compounding interest can increase your debt if used incorrectly. This is because the money you owe will compound over time.
Let’s Calculate Compound Interest
Now that we understand what compound interest is, let’s determine how to calculate it. There are several ways to do the calculations, the quickest way is using a compound interest calculator on Google. If you want to learn the traditional way, you can use this formula instead.
Total principal and Interest = P(1+i)^n
where,
P = principal amount (original amount invested/saved)
i = interest rate for the compounding period
n = number of compounding periods
First, solve the parenthesis, then the exponent, and multiply by the original amount to get the total principal and interest.
For example:
Let’s say you invest $5,000 into a high-interest savings account at an annual interest rate of 1.5% that is compounded monthly. In a year you will earn $75 of compound interest, here is how:
P= $5,000
i= 0.125% ( 1.5% annual interest, divided by 12 months)
n= 12
$5,000(1+0.00125)^12
=$5,000(1.00125)^12
=$5,000 x 1.0151
=$5,075 total principal and interest
What Financial Products use Compound Interest?
While there are several products that will help you earn compounding interest on your savings, there are also others that don’t.
The following are the most common types of products that use compound interest:
- Savings accounts
- Mortgages
- Certificates of deposit (CDs)
- Loans
- Bonds and Bond Funds
- Guaranteed Investment Certificates (GICs)
Now you know what compound interest is, how to calculate it and what financial products will help you compound interest.
If you want to further explore how interest works, how credit card interest is calculated or if you are looking for more information, check out our Personal Finance Guides that includes understanding credit and debt.
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